Organizational Industrial Economics
Andy Newman
Boston University and CEPR
ECARES@20: May 2012
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[Industrial Economics] is concerned with how productive activities are
brought into harmony with society’s demands for goods and services
through some organizing mechanism such as a free market, and how
variations and imperfections in the organizing mechanism affect the degree
of success achieved by producers in satisfying society’s wants.
– Scherer (1980)
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Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
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Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
4 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
5 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
6 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
Why now for an Organizational IO?
7 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
Why now for an Organizational IO?
I
The tools are there
8 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
Why now for an Organizational IO?
I
The tools are there many developed by ECARES members and
associates
9 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
Why now for an Organizational IO?
I
I
The tools are there many developed by ECARES members and
associates
New data sets; boundaries of firms and other organizational measures
are becoming become available
10 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
Why now for an Organizational IO?
I
I
I
The tools are there many developed by ECARES members and
associates
New data sets; boundaries of firms and other organizational measures
are becoming become available
interest in IO (and many other parts of economics) in heterogenous
firm behavior and performance
11 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
Why now for an Organizational IO?
I
I
I
I
The tools are there many developed by ECARES members and
associates
New data sets; boundaries of firms and other organizational measures
are becoming become available
interest in IO (and many other parts of economics) in heterogenous
firm behavior and performance
recent empirical work in industries as diverse as airlines and concrete
emphasizing ownership structure’s relation to prices and performance
12 / 45
Organizational Economics and Industrial Economics
IE is the study of how firms deliver the goods
In IE, firms’ conduct deviates from the Arrow-Debreu ideal because of
imperfections in the market
Imperfect competition is only one source of distortion
So is the makeup of the industry’s constituents, i.e., the internal
organization of firms
Why now for an Organizational IO?
I
I
I
I
I
The tools are there many developed by ECARES members and
associates
New data sets; boundaries of firms and other organizational measures
are becoming become available
interest in IO (and many other parts of economics) in heterogenous
firm behavior and performance
recent empirical work in industries as diverse as airlines and concrete
emphasizing ownership structure’s relation to prices and performance
Public discussion and events: Enron, MCI, Continental 3407, British
rail, lead toys, CEO pay, banking crisis
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Questions for an “Organizational Industrial Organization”
What deviations from the Arrow-Debreu benchmark can imperfections
within firms be expected to generate?
Do these departures differ from those generated by imperfectly
competitive product markets? (OE helps IO)
Two-way street: organization is endogenous, so the market could be
expected to influence organization (IO helps OE)
Start with perfect competition so that market imperfections don’t
cloud issues
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Questions for an “Organizational Industrial Organization”
What deviations from the Arrow-Debreu benchmark can imperfections
within firms be expected to generate?
Do these departures differ from those generated by imperfectly
competitive product markets? (OE helps IO)
Two-way street: organization is endogenous, so the market could be
expected to influence organization (IO helps OE)
Start with perfect competition so that market imperfections don’t
cloud issues
I
This leaves open an important issue (future research) namely the
structure of competition is itself endogenous to organizational design
(e.g., firm boundaries)
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What We Do
Legros and Newman, ”A Price Theory of Vertical and Lateral Integration”
Look at an “incomplete contracts” model in which product market
prices interact with organizational design decisions in a perfectly
competitive environment
Prices affect organizational design by affecting the trade-off between
financial and private motives of managers
Embed this organizational model into a standard supply-demand
framework
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What We Learn
Determinants of organizational choices are often to be found outside
the firm
In particular, demand matters as well as liquidity
Consumers — who are usually absent from organization theory — are
affected by organizational choices
An organizational IO can tell us whether the market selects “efficient”
organizations.
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Ingredients of a Model
Efficient production requires coordination; managers disagree on
which way is best (Hart-Holmström, 2002/10)
Non-integration: managers make their decisions separately, and this
may lead to inefficient production
Integration: brings in an additional party (“HQ”) who has only
monetary motives and will therefore maximize the enterprise’s output
by enforcing a common standard
Supplier and product markets are perfectly competitive
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Results
Relation between price and organization embodied in supply curve
(the “OAS”): non-integration at low prices, integration at higher
prices
Changes in price lead to coordinated changes in organization: e.g., an
increase in demand may lead to a flurry of integration, i.e., a “merger
wave.”
Shocks to some firms (e.g., productivity) propagate and lead to
reorganization of “unshocked” firms
These organizational effects will in turn feed back to quantity, price,
and welfare: possibly too little integration at low prices
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Technology
Two types of supplier: A and B; production requires one of each be
paired
Economy has large numbers of each type, with A’s outnumbering the
unit measure of B’s
Large number of HQ’s (more than the number of B’s)
For each provider, a decision is rendered indicating the way in which
production is to be carried out.
A decision a ∈ [0, 1], and B decision b ∈ [0, 1]
Minimizing output loss requires decisions made in each part of the
firm should coincide: output is
I
I
I
2
1, with probability 1 − (a − b)
0, with remaining probability
outcomes independent across firms
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Managers
Each supplier run by a risk-neutral manager
I
I
I
I
A manager’s payoff is y − (1 − a)2 : “1” is best
B manager’s payoff is y − b 2 : “0” is best
y ≥ 0 is income
cost functions reflect differences in the technology managers run,
differences in conduct workforces find convenient, or disagreement over
best ways to manufacture or market product
A and B managers have zero cash endowments
HQ’s have zero opportunity cost, preferences y and cash endowments
h>0
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Contracts
Decisions are not contractible
Costs are private and non-contractible
Right to make decisions can be reassigned by contract
Output generated by the firm is contractible (for monetary incentives)
Managers bear the cost of decisions even if they don’t make them
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Tradeoffs
Change of organization =⇒ change in incentive problem
Non-integration: managers undervalue coordination, overvalue private
costs.
Integration: HQ undervalues managers’ costs, overvalues
coordination.
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Markets
Supplier Market
B managers match with A managers;
A’s are on the long side and B’s are on the short side
HQ market
Contracts
Ownership structure of the relationship: nonintegration (N) or
integration (I )
Shares s (endogenous) of managerial revenue P accruing to manager
A, B and HQ if relevant.
Ex-ante transfers πA , πB from HQ to A, B.
Product Market
Competitive, demand function is D(P)
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Comparing Organizations
Managerial Payoff Comparison
W N (P) > W I (P) if P < 1.
Ownership structure depend on price
For low (< 1) prices non-integration dominates,
For higher (> 1) prices, integration preferreda
a
Provided surplus is not distributed equally between A and B
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“The Organizationally Augmented” Supply Curve
Assume u A = 0. Let α be the fraction of integrated firms; total supply at
price P is then
2 !
1
,
S (P, α) = α (1) + (1 − α) 1 −
|{z}
1+P
integration
|
{z
}
nonintegration
where
(
0
α=
1
if P < 1
if P > 1
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“The Organizationally Augmented” Supply Curve
P
N
I
I
1
mix
N
1
Q
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Application: Technological Shocks
Uniform 10% Productivity Increase
P
Sinitial
Safter
d
a
1
c
1/1.1
d
Q
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Application: Re-Organizational Dampening
10% of Firms Double Productivity
P
Sinitial
1
Q
Application: Re-Organizational Dampening
10% of Firms Double Productivity
P
Sinitial
Sshocked
1
1/2
Q
Application: Re-Organizational Dampening
10% of Firms Double Productivity
P
Sinitial
Safter
Sshocked
d
a
1
b
1/2
d
Q
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Summary
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Summary
A firm benefiting from a technological shock may not re-organize
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Summary
A firm benefiting from a technological shock may not re-organize
A firm that undergoes a large re-organization need not have
experienced a change in technology
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Summary
A firm benefiting from a technological shock may not re-organize
A firm that undergoes a large re-organization need not have
experienced a change in technology
Re-organizational dampening may substantially absorb the aggregate
benefit of heterogenous technological change
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Welfare
Definition
Definition
An equilibrium is ownership efficient if it is not possible to increase total
welfare by changing firms’ ownership structures.
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Welfare
Ownership Efficiency
Ownership Efficiency
When managers have full residual claim on revenues, equilibria are
ownership efficient.
Reason: marginal private cost schedule coincides with supply curve
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Welfare
Ownership Efficiency
Ownership Efficiency
When managers have full residual claim on revenues, equilibria are
ownership efficient.
Reason: marginal private cost schedule coincides with supply curve
“Managerial” Firms
Managers internalize only a fraction γ of the firm’s profits
Choices at P are made as if the price were γP
Main consequence: supply curve no longer coincides with marginal
cost
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P
Supply(γ)
d
1/γ
c 0 (Q)
Q N (γP)
1
0
d
Q
Figure: Ownership Inefficiency when Managers have a Partial Claim on Revenues
P
Supply(γ)
d
1/γ
c 0 (Q)
ODWL
Q N (γP)
1
0
d
Q
Figure: Ownership Inefficiency when Managers have a Partial Claim on Revenues
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Proposition
Suppose that γ < 1. Then if the demand is such that the equlibrium price
is P ∈ (PN (γ), 1/γ), equilibria are ownership inefficient
Demand Elasticity
The more elastic market demand is, the larger is the ODWL
Opposite relationship with market power: there the more elasticity is
the lower is the DWL.
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Application: International Trade
Application: International Trade
Application: International Trade
Application: International Trade
Conconi, Legros, and Newman, “Trade Liberalization and
Organizational Change,” Journal of International Economics, 2012
Application: International Trade
•  Embed this industry model into a two-country, multisector trade model
Application: International Trade
•  Embed this industry model into a two-country, multisector trade model
•  Trade liberalization changes prices, leading to
mergers/divestitures
Application: International Trade
•  Embed this industry model into a two-country, multisector trade model
•  Trade liberalization changes prices, leading to
mergers/divestitures
•  Cross-border movements of firms also lead to
reorganization, including harmful outsourcing:
Application: International Trade
•  Embed this industry model into a two-country, multisector trade model
•  Trade liberalization changes prices, leading to
mergers/divestitures
•  Cross-border movements of firms also lead to
reorganization, including harmful outsourcing:
•  In theory, consumers may be worse off after
liberalization
•  In practice, Mattel lead toys can be traced to Chinese
growth
Conclusion
Demand Matters for Organizations
Coordination device, “clustering” of organizational changes. Prices may increase
following entry of low cost suppliers. Shocks propagate.
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Conclusion
Demand Matters for Organizations
Coordination device, “clustering” of organizational changes. Prices may increase
following entry of low cost suppliers. Shocks propagate.
Organization Theory Matters for Industrial Economics
Organization is an important determinant of “conduct” and performance of firms.
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Conclusion
Demand Matters for Organizations
Coordination device, “clustering” of organizational changes. Prices may increase
following entry of low cost suppliers. Shocks propagate.
Organization Theory Matters for Industrial Economics
Organization is an important determinant of “conduct” and performance of firms.
Governance Matters for Consumers
Consumers have an interest in the internal organization of firms even absent
market power
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Conclusion
Demand Matters for Organizations
Coordination device, “clustering” of organizational changes. Prices may increase
following entry of low cost suppliers. Shocks propagate.
Organization Theory Matters for Industrial Economics
Organization is an important determinant of “conduct” and performance of firms.
Governance Matters for Consumers
Consumers have an interest in the internal organization of firms even absent
market power
Mind your P’s and Q’s: IO as a proving ground for OE
Other models of the firm can be embedded in the market and would lead to
different versions of the OAS; may distinguish them empirically based on
price/quantity data
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